If a country is on a fixed exchange rate régime and suffers a sudden temporary negative demand shock, which would be the most appropriate policy response?

Question

BlackTom AI · Accepted Answer

First, let me restate the situation and the available choices, noting that the provided data has an empty list of answer options and identifies a single proposed correct option: reduce taxes.
In a country operating under a fixed exchange rate regime, a sudden temporary negative demand shock reduces domestic demand and can threaten output and employment. With a fixed exchange rate, monetary policy is constrained because offsetting price-level or demand shocks through interest rate changes risks destabilizing the peg; the central bank must defend the fixed rate rather than pursue an independent monetary stimulus.
Now, considering policy responses to the shock: 
- Reducing taxes as a fiscal stimulus option can increase aggregate demand by leaving households and firms with more disposable income, thereby encouraging consumption and investment. Since monetary policy is limited by the fixed exchange rate, fiscal expansion becomes the main tool to counteract the fall in demand. This makes tax cuts a plausible response to support demand without altering the exchange rate.
- Other potential options (not provided in the list) would include increasing government spending or targeted fiscal measures to raise demand, which would also be expansionary under a fixed peg and help stabilize output.
- Devaluing or pursuing a literal depreciation of the currency would undermine a fixed exchange rate regime, since the central bank would have to adjust the peg or face reserve losses; this is typically not feasible or desirable under a fixed regime during a shock because it would entail moving away from the fixed rate commitment.
- Tightening monetary policy (raising rates) would worsen the demand shock by reducing credit and spending, and is generally inconsistent with countercyclical stabilization in the face of a downturn under a fixed peg.
- In a scenario with a fixed exchange rate, relying on exchange-rate adjustments to stimulate the economy is not an option, since the exchange rate is fixed and authorities must maintain the peg, limiting monetary policy autonomy.
Given these considerations, the most coherent response among typical options is to use expansionary fiscal policy, such as tax cuts, to raise aggregate demand while keeping the exchange rate fixed.
Note on the missing answer options: since no alternatives are provided, I focused the analysis on the rationale for a fiscal expansion (tax cuts or increased spending) as appropriate under a fixed exchange-rate regime facing a negative demand shock, and contrasted it with reasons why monetary and exchange-rate adjustments would be inappropriate in this setting.

If a country is on a fixed exchange rate régime and suffers a sudden temporary negative demand shock, which would be the most appropriate policy response?Single choice

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